Examining the Fed’s other policy options « self-evident

Examining the Fed’s other policy options « self-evident

Thanks to Jon Hilsenrath’s latest piece in the Wall Street Journal and this piece from Reuters, everyone is talking about how the Fed is exploring other measures to stimulate the economy. It’s difficult not to be underwhelmed by this discussion for two reasons. First, it is not at all obvious that the Fed needs to take action, even though the curve suggests it is forthcoming (hat tip @Fullcarry). Economic data appear to show signs of deterioration and there remain significant downside risks to the economy from Europe and US fiscal policy (or lack thereof). But a large part of the perceived deterioration could potentially be attributed to temporary factors and housing is recovering. And as others have noted, bank credit is actually expanding. These trends should support the Fed waiting to take action, however much market participants want additional intervention. Second, most of the “other tools” being hyped either are not live options for the Fed or are not politically feasible. (And let’s be honest, the Fed’s performance in the current environment is fundamentally a political enterprise.)
So what are the “other tools” everyone is talking about?
Reduce the 25-bp interest rate on excess reserves (IOER) – This does not seem like a live option for the Fed, although Bernanke continues to list it as a possibility in testimony, presumably because it would appear to support the idea that the Fed has not run out of ammunition and because lawmakers have no idea what he’s saying anyway. (“Dr. Bernanke, what exactly is this situation with Greece?”)
The theory behind reducing IOER is that it would encourage bank lending. At 25 bps, IOER is higher than comparable assets (short-term Treasuries), which gives banks an incentive to hold excess reserves. If the Fed cut IOER to zero, banks would then have an incentive to divest (read: make loans, not park money at the Fed risk-free).
In reality, this will not be a useful tool if loan demand remains low, and it would likely result in dysfunctional money markets and negative Treasury bill yields, which would complicate auction processes. (Bank of America Merrill Lynch and others have indicated in recent commentary that such a move would likely result in an increase in the effective fed funds rate as bank borrowing from GSEs – which are ineligible to earn interest on Fed balances but lend in the fed funds market – declines.)